Wholesale Savings

During California’s recent drought, the utilities that own their supply sources conserved more than the those that purchase water from wholesale suppliers

-Warning: this post contains hardcore wonkery-

A while ago I blogged about my ongoing work with Youlang Zhang and David Switzer on water conservation in California. The first of our studies is now published at Policy Studies Journal; more are on the way. There we saw that financial incentives and institutional politics led to the surprising result that private, for-profit companies out-conserved local government utilities during a recent drought.

But another interesting pattern emerged from that study: a significant difference in conservation between utilities that draw their water supplies from wholesale sources.

Where utilities get their water

The drinking water utilities that serve American communities get their water in one of three ways*:

1) Pumping groundwater from wells that tap underground aquifers;

2) Drawing surface water from lakes and rivers; or

3) Purchasing water from a wholesale water utility.

In the first two cases, local utilities own wells, surface water intakes, and treatment plants. About 29% of American utilities fall in the third category, getting their water through wholesalers. In these cases, the local utility owns a distribution and/or storage system, but the supply works and perhaps the treatment facilities belong to another utility. Sometimes these wholesale utilities have retail customers of their own, sometimes they are purely wholesale suppliers.

Spreading the risk

A major advantage of big wholesale water utilities is that they allow a region’s water supply to be managed holistically and comprehensively. Rather than individual communities competing and depleting water supplies, regional wholesalers can plan and balance water supply needs. From the local perspective, wholesale utilities help diversify supply and so guard against catastrophic supply shortages. They also allow communities across a region to pool their capital for greater efficiency. Together these features spread both supply risk and financial risk across many local utilities.

“Take-or-pay”

Sales agreements between retails and wholesalers vary widely across the country, so generalizing is difficult. But one common feature of wholesale contracts is the take-or-pay provision. Under take-or-pay arrangements, the wholesaler agrees to supply and the retailer agrees to purchase a fixed volume of water over a given period of time for a given price. If retail demand exceeds the contract volume, the retailer pays for more on a volumetric basis. If retailer demand falls short of the contracted volume, the take-or-pay provision requires the retailer to pay the wholesaler anyway, as if it had used the entire contract volume.†

In other words, under take-or-pay contracts, the retailer pays the wholesaler the same amount, even if the retailer uses far less water than the contracted volume.

Wholesale supply & the logic of conservation

Got all that? Still with me?

Here’s what it all means for conservation. Wholesale supply arrangements reduce supply risk and long-term financial risk to local utilities. Take-or-pay contracts make a lot of sense for long-term stability for supply systems that have high fixed costs.

But in the short-term, these wholesale arrangements create disincentives for retail conservation during a drought. Under wholesale agreements, short-term supply risk from drought is shifted from the local utility to the wholesaler: the wholesaler is legally responsible for maintaining adequate supply. Meanwhile, fixed take-or-pay contracts leave retailers on the hook for the same amount no matter how much water their customers actually buy. The retailer may suffer significant sales declines if it rains all summer, or if the state imposes drought restrictions, but the retailer still has to pay the wholesaler as if demand was normal.

Wholesale $avings

Does diluting risk also dilute conservation? As I explained in an earlier post, the recent drought in California prompted that state to impose conservation rules on retail water utilities from June 2015-May 2016. Each utility was assigned a specific conservation target and the state recorded overall conservation by each utility.

Did utilities that operate under wholesale supply arrangements perform differently from utilities that own their own supplies?

Our analysis of data from the drought mandate period is pretty striking. After accounting for a host of organizational and environmental conditions, we found that water systems that rely on wholesale water supplies were 42% less likely to meet state conservation standards, compared with systems that own their own supplies.

We also found that, after accounting for other factors, utilities under wholesale contracts conserved an average of 2.6% less each month relative to systems that use their own wells or surface water sources. In a state as large as California, this small percentage difference equates to tens of billions of gallons.

Follow the money

These patterns don’t prove that wholesale contracts caused California utilities to slack on conservation. But the data certainly align with the short-term incentives that wholesale supply arrangements create, and there aren’t other obvious reasons for the disparity. The lesson here is to pay close attention to wholesale contracts when setting conservation rules, so that conservation and financial incentives work in concert.

*Technically there are other sources, too—desalination and water reuse, for example–but they’re so rare that they don’t allow for much meaningful analysis.

†”Take-or-pay” is a weird phrase, since there’s really no “or” to the arrangement. Seems like “fixed fee” is a more accurate label, but then I’m not a lawyer.

2 responses to Wholesale Savings

Brian Thomas

I am wondering if the results in MWD’s service area were different. MWD does not have take or pay contracts with its members. In fact, during the drought they use a “penalty” rate structure to encourage agencies to take less water.

Great question. We didn’t analyze conservation responses with retail utilities grouped by wholesale supplier, but we could. We’d expect to see varying responses based on contractual structure. I’ll look into it when I get a chance and follow up this post when I have an answer.